The Setting Every Community Up for Retirement Enhancement Act (SECURE Act) that went into effect at the beginning of 2020 aims to expand, preserve, and encourage retirement savings1. One of the many provisions in this act is the elimination of the “stretch-IRA” whereby an IRA owner would make a member of a future generation, such as a child or grandchild, their IRA beneficiary who could then withdraw the IRA funds over their much longer expected lifetime. The resulting inherited IRA funds could be “stretched” for decades after the death of the original IRA owner. Stretching out the IRA withdrawals allowed the assets more time to grow tax-free and then be taxed at a possibly lower rate when withdrawn by the much younger beneficiary.
SECURE Act Eligible Designated Beneficiary
As in the past, the SECURE Act bases the annual required minimum distribution (RMD) on the life expectancy of the following “eligible” designated beneficiaries:
Surviving spouse of the deceased owner,
Minor child of the deceased owner,
Chronically ill person, and a
Person that is not more than ten years younger than the deceased owner.
SECURE Act 10-Year Rule
Following the death of an “eligible” designated beneficiary, or when the minor child of the deceased owner reaches the age of majority, the IRA assets must be withdrawn within ten years. All “non-eligible” designated beneficiaries must withdraw the inherited IRA funds within ten years from the death of the original IRA owner. When subject to this 10-year rule, there is no longer an annual RMD; all remaining IRA assets could be withdrawn in the tenth year.
Deferred Gifts Funded by IRA Testamentary Direct Transfers
IRA owners with a charitable intent who wish to stretch their IRA funds beyond ten years after their death have found a solution that utilizes deferred giving strategies such as a testamentary charitable gift annuity and a testamentary charitable remainder trust. Multiple IRS Private Letter Rulings have indicated that a direct transfer from an IRA upon the death of the owner to a charitable remainder trust would not result in the recognition of ordinary income by the decedent’s estate. The same is true for an IRA testamentary transfer to fund a gift annuity where, in addition to the non-recognition of income by the owner’s estate, the charity would not recognize unrelated business taxable income because of the transfer.
"IRA owners with a charitable intent who wish to stretch their IRA funds beyond ten years after their death have found a solution that utilizes deferred giving strategies..."
Testamentary Charitable Gift Annuity
A charitable gift annuity is an arrangement whereby assets are given to a charity in return for the charity’s promise to make payments of a fixed amount to the beneficiary designated by the donor. An IRA owner can designate a charity as their beneficiary in exchange for the charity’s promise to issue an annuity to a person selected by the IRA owner. The IRA owner would enter into a gift annuity agreement with the issuing charity that would not be effective until and unless the IRA assets remaining at the owner’s death are actually transferred to the charity. It is important to include a provision in the agreement that the amount paid to the annuitant will be determined when the IRA testamentary transfer occurs since there are payout-based “gift annuity qualification” tests that change over time and must be met when the gift annuity is funded.
The payout from a gift annuity could begin immediately, or may be deferred, and continues for the remaining life of the annuitant. Under a Deferred Gift Annuity, an annuitant receives payments that begin more than one year after the death of the IRA owner. A Flexible Deferred Gift Annuity leaves the determination of the beginning date to the annuitant who may delay their “start-date” decision for several years. The amount paid each year increases the longer an annuitant waits to begin receiving the payments.
Since the IRA assets transferred to fund a charitable gift annuity have a zero tax basis (IRA owner never paid tax on these funds) it follows that all of the annuity payments will be characterized as ordinary income to the annuitant.
Testamentary Charitable Remainder Trust
An IRA owner can designate a charitable remainder trust (CRT) as the beneficiary of their IRA. A CRT makes periodic beneficiary distributions to a non-charitable beneficiary, and whatever remains in the trust upon its termination goes to charity. The beneficiary payments can be fixed in amount, as in a charitable remainder annuity trust, or vary each year based on the trust’s market value, as in a charitable remainder unitrust.
A standard unitrust makes periodic payments to an income beneficiary based on a percentage (payout rate) of the trust’s value determined each year. A net income unitrust is an arrangement where the amount distributed to the beneficiaries is the lessor of (1) the payout rate applied to the trust’s assets (percent limitation), and (2) the distributable trust income. A flip unitrust is an arrangement that begins as a net income unitrust then converts (flips) to a standard unitrust at a pre-determined date or upon the happening of an event such as the sale of unmarketable/illiquid trust assets.
Unlike the receipt of IRA funds which are characterized as ordinary income by the recipient, the type and amount of income reportable on the beneficiary’s personal tax return from the receipt of charitable remainder trust distributions are based on the amount and type of income earned by the trust investments.
"Unlike the IRA payout, all of which is taxed as ordinary income to the beneficiary, the unitrust payout would only be characterized as ordinary income to the extent that ordinary income was received by the unitrust investments."
As an example, assuming net investment returns of 5% for both the post-death IRA investments and a standard unitrust with a 6% payout to a beneficiary age 55, the 10-year IRA payout would total about $323k compared to the estimated 33-year2 unitrust payout of $414k. Unlike the IRA payout, all of which is taxed as ordinary income to the beneficiary, the unitrust payout would only be characterized as ordinary income to the extent that ordinary income was received by the unitrust investments. Assuming that interest and dividends comprise 1/3 of the unitrust net return, 2/3 of the unitrust payout would be characterized as realized gains or nontaxable return of principal. Additionally, at the end of the projected 33-year unitrust term about $171k would remain for charity. Lastly, the present value of the unitrust income interest, which is a “gift” to a non-spouse, would be about $185k.
Gift Tax and Generation Skipping Transfer Tax
There may be gift tax implications when an IRA owner designates someone other than their spouse as the income beneficiary of a gift annuity or charitable reminder trust. Generation skipping transfer tax may apply when the income beneficiary is two or more generations below the IRA owner, such as a grandchild or great-grandchild. The amount “gifted” is the present value of the future beneficiary payments. Due to the unusually high exemption of $11.58 million (2020), these taxes are rarely an issue.
We encourage you to speak with us if using a testamentary charitable trust or testamentary charitable gift annuity in lieu of a stretch-IRA is of interest to you. Additionally, a long-form version of this article which explores this topic in greater detail is available.
1 The provisions of the SECURE Act apply to IRA owners who die after 2019. 2 Average of male and female life expectancies of a person aged 55.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.